Concerns about business expenses rank high for the companies taking part in the NFIB’s 2020 Small Business Problems and Priorities Survey. Respondents report that their No. 1 challenge is the cost of health insurance, with local, state and federal taxes and the price of supplies and inventory also landing in the top 12.
By gaining a better understanding of the nuances of various expenses, business owners can decide where to spend more, where to cut and how to project payables to keep cash flow in focus.
What Is an Expense?
For purposes of accounts payable (AP) accounting, all expenses are costs, but not all costs are expenses.
A cost is the amount paid to purchase inventory, manufacture and sell a product and acquire equipment via capital expenditures. Expenses are what the business spends to generate revenue during a given period and are recorded on the income statement as an offset to that revenue or income.
Essentially, expenses are outlays that relate to the day-to-day running of the business, such as payroll, utility bills, rent payments and more.
Capital expenditures are purchases of assets, like vehicles, machinery or business licenses. The cost to acquire an asset is shown on the company’s income statement, as is the cost to maintain it. Assets themselves, capital and liquid, do not appear on the income statement, however. They appear on the balance sheet.
That doesn’t mean that assets don’t bring expenses: What keeps a capital expenditure in service — gas, maintenance, the person operating the machine — are operating expenses. Likewise, depreciation and amortization of the asset are expenses and are included on the income or P&L statement as operating expenses, typically under selling, general and administrative (SG&A).
Note that depreciation is based on an asset's estimated useful life, not the number of years it’s expected to be in use. Assets are often kept in service long after they have been fully depreciated.
Essentially, if your company receives and pays an invoice, that’s an expense. The process of paying bills is a subset of the accounts payable (AP) function. Upon receiving an original invoice or purchase order, someone in the AP department reviews it to ensure all details are accurate and compliant with policies.
Expenses are charged against revenue on the company’s monthly income statement and can generally be categorized as operating or non-operating expenses.
Operating expenses, sometimes called OpEx, are the ongoing costs to fund day-to-day business operations. These can be fixed, like utilities, rent, salaries, property taxes and pension plan contributions, or periodic, such as quarterly taxes and business travel, to name a few.
Non-operating expenses are expenditures that are indirectly related to operations and the result of financing or investing activities, such as depreciation and amortization and interest payments on loans and credit cards.
As discussed, capital purchases and outlays related to producing goods are costs.
Capital expenses are large items, like a building or machinery, that depreciate over time.
Cost of goods sold (COGS) represents the direct costs of making or acquiring the products that generate revenue. A services organization may simply call this “cost of sales,” since it doesn’t sell “goods.”
For example, say a pack-and-ship storefront decides to start a delivery service. It finances the purchase of a $40,000 cargo van, which is a capital expenditure; it will have that vehicle for many years and not have to pay the full purchase price again. But it will have to keep paying the interest on the loan and recurring operating costs to keep the van generating revenue, including fuel, insurance, maintenance, tolls and the delivery driver’s salary — these are expenses.
Common operating expenses include rent, utilities and insurance. From there, typical expenditures vary by company type: Restaurants order food from a variety of suppliers. A medical practice may pay a specialized cleaning company. Our pack, ship and delivery service spends on office supplies and fuel.
Expenses may be fixed — that is, stable despite changes in production volume or service delivery — or variable, meaning they fluctuate. The interest on the van and the delivery driver’s salary are fixed expenses, while fuel and tolls are variable.
Expenses are either consumed immediately, like fuel, or represent the reduction in value of a physical or intangible asset, like depreciation on the delivery van’s value. From an AP perspective, unlike physical or intangible assets, such as a patent or brand, once expenses are “consumed,” they have no future value.
5 Deductible Expense Categories Business Owners Might Miss
Continuing education: Business owners can deduct the cost of training and seminars to upskill their workforce or stay current on industry trends.
Dues and subscriptions: Along the same lines, industry magazines or journals related to your business can be deducted on your taxes, as can membership fees paid to your local Chamber of Commerce and professional or trade associations that help promote your company.
Business use of your car: You may be able to write off the costs of maintaining and operating a vehicle used strictly for business. However, if it’s mixed, you can claim mileage related to the business use.
Startup expenses: Businesses that launched a new venture — like our delivery service — may be able to deduct up to $5,000 in startup expenses, such as marketing and employee training.
Software as a Service (SaaS): Applications, such as bookkeeping software, or recurring subscription with SaaS companies, used for business related purposes may be fully tax deductible.
Steps in the process to record and pay expenses include setting up a new vendor in your accounting software, creating and approving a purchase request, creating and approving a purchase order, approving the invoice, paying for the item, managing any returns or adjustments, calculating taxes due and generating AP and other needed reports.
To properly record — and deduct — business expenses, you need to keep documentation. Supporting expense documents required by the IRS should show proof of payment and identify the payee, the amount paid, the date the expense was incurred and include a description of the item purchased or service received that shows the amount was for a legitimate business expense.
The IRS also specifies how long various records need to be retained.
Documentation for expenses include:
- Canceled checks or other proof of payment/electronic funds transferred
- Cash register tape receipts
- Account statements
- Credit card receipts and statements
Companies use either the accrual or cash-basis accounting method for recording expenses.
The accrual method is the most common. In accrual accounting, the company recognizes the expense when it is incurred, regardless of when it pays for the good or service. The company ledger reflects amounts the business owes but hasn’t yet paid.
The cash-basis method is more straightforward. Businesses using cash basis accounting record revenue when it’s actually received — say, when a check is deposited, clears and cash lands in the account — and expenses when a payment is made.
Expenses are recorded on an income statement. An income statement reports a company’s revenue, expenses and profit or loss during a specific accounting period. Income statements are also known as profit and loss statements, or simply “P&Ls,” among other names.
Types of Expenses
Expenses are either operating expenses or non-operating expenses. Operating expenses relate to day-to-day activities. Non-operating expenses, such as interest payments, are not incurred as part of a company’s core operations. Within those buckets, expenses are either fixed — they generally don’t change during the year — or variable, meaning they fluctuate. Rent and salaries are fixed operating expenses. Fuel and sales commissions are variable.
Remember, cost of goods sold (COGS) is a separate category. If an outlay represents a direct cost of making or acquiring the products that generated revenue during the period rather than the day-to-day cost of doing business, it’s COGS.
For tax purposes, expenses should be grouped into categories, such as selling, general and administrative expenses (SG&A). Misidentifying expenses can result in businesses unnecessarily missing out on deductions or incurring IRS penalties.
SG&A: Includes all non-production operating expenses, including the costs to promote, sell and deliver products — rent, salaries, commissions, advertising and marketing.
Depreciation: This reflects a fixed asset’s loss in value over time and may be listed in different parts of the income statement, depending on the asset. Amortization applies to intangible assets, such as patents.
What Is a Non-Cash Expense?
A non-cash expense is recorded on the income statement but doesn’t require a cash payment. The most common non-cash expense is depreciation, but asset write-downs, such as for obsolete inventory, and stock awarded as compensation are other examples.
If our pack-and-ship company paid cash for the delivery van, depreciation would not directly affect its cash flow, but it may have an indirect effect. For instance, many companies are required to pay estimated taxes quarterly. Depreciation decreases overall taxable income and therefore decreases tax liability, allowing the company to retain more cash.
Tax Deductible Types of Expenses
To be deductible, an expense must be what the IRS considers “both ordinary and necessary.” The agency defines an ordinary expense as one that is common and accepted in your industry, while a necessary expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable to be considered necessary; for example, deciding to run a social media ad campaign is discretionary but still deductible.
But there are exceptions: If an expense was factored into the cost of goods cold (COGs), it cannot be deducted again as a business expense. Capital expenditures and personal expenses are likewise not deductible, nor are lobbying costs or political donations.
Employee compensation, retirement plans, vehicles used for business, rent, insurance and interest are deductible, as are various federal, state, local, and foreign taxes directly attributable to your trade or business.
Note that the Tax Cuts and Jobs Act made changes to what’s deductible, along with rules around depreciation, tax credits and more. For example, companies can no longer deduct the costs of entertaining customers at sporting events, though meals are partially deductible.
IRS Publication 535 lists all deductible business expenses.
How to Automate Expense Reporting
Accounts payable automation, or AP automation, brings together tools and a set of best practices to automate the manual aspects of approving, classifying, tracking and paying valid business expenses. Payroll, often one of the largest expenses, can also be part of AP automation by sending payroll tax liabilities to AP for payment each period.
Rather than a finance team member entering supplier data, approving POs and paying bills manually, with accounting software, the entire process can happen digitally, with finance teams getting involved only when the system flags an anomaly. Besides looking for inaccuracies, like transposed numbers, an automated review process looks for signs of fraud, ensures an invoice isn’t a duplicate and checks the supplier’s terms for due dates and any early-payment discounts. That saves time and money while minimizing fraud and errors.
To automate the expense process, most businesses turn to modern accounting and financial management software. These systems are essential for tracking revenue and expenses, generating financial reports and helping finance keep an eye on the financial health of the business. It reduces errors inherent in manual data entry and generates accurate financial statements and reports that comply with U.S. GAAP and IFRS accounting standards.